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7 Deadly Sins of Personal Finance: Skipping Emergency Funds

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7 Deadly Sins of Personal FinanceThis is the first of a series of seven posts titled the 7 Deadly Sins of Personal Finance. In the next week, I’ll discuss seven mistakes I think we must avoid if we’re going to be successful managing our money. They’re things I’ve learned the last few years as both a personal finance blogger and manager of my own money in our ever changing world. Hopefully you can both take something away from these and give me your own take on the points I bring up.

Without further ado, the first deadly sin of personal finance is…

Not Having An Emergency Fund

An emergency fund is a fund that you set aside specifically to handle the unforeseen emergencies in your life. Some save as little as three months of expenses, others save as many as a year’s worth of expenses, we are going with six months plus adjustments for extenuating or mitigating circumstances. Currently our emergency fund is at six months with no adjustments because we have two incomes and that mitigates the risks brought on by a slowing economy. If we were single income, I might adjust that upward to seven or eight months. If we had kids, I’d adjust it to a full twelve. It’s better to be safe than sorry, you won’t lose much, especially in this economy, by having too much in your emergency fund.

Why is an emergency fund important? When you have a pot of money set aside for emergencies, you don’t need to rely on loans or credits to pay for the emergency. A prime example is a simple flat tire in your car. A flat tire can happen any day and, while not catastrophic, can cost you anywhere from a hundred to two hundred dollars. If you have an emergency fund, you can pay for the service without worrying about adding to your existing debt. With an emergency fund backing you up, you don’t have ride on your donut spare tire (very dangerous!) until your next paycheck.

A flat tire is easy, what about something bigger? Sticking with the car theme, let’s say a rock cracks your windshield when you’re driving to work. Windshield replacement is a little more expensive. With an emergency fund, you can quickly pay for a repair or replacement that can prevent further emergencies down the road. Driving with a cracked windshield is extremely dangerous and with an emergency fund you can take care of those problems quickly and before they develop into bigger problems.

How should you save? This is the easy part. The first step is to budget and figure out how much your monthly expenses are. If you don’t have any empirical data, here’s what I’d do. First, get a ballpark estimate of expenses by calculating what 75% of your pre-tax income is. Use that as your expenses numbers for the first month while you collect data, then replace it with the actuals once you have them.

The best place to save is to open a high yield savings account at an online bank and set up an automatic transfers each month from your checking account. Don’t put it in the stock market, don’t put it in any other investments, and don’t leave it in your checking account where it won’t accrue interest.

That’s it! And like that, you have an emergency fund. If you didn’t have one before and you’re now worried your fund is small, don’t worry. You have a plan in place now and it’s just a matter of time before the savings accumulate. In the event that you do experience an emergency before the fund can handle it, you’re no worse off now than you were before you started the fund. Handle it as you would’ve but keep following the plan.

One last bit of advice: Don’t spend that fund unless it’s on a true emergency. I’ve heard of stories where people have stumbled on a “great investment tip” and raid that fund (you should set up an opportunity fund for that). Don’t. The purpose of that fund is to make sure you don’t fall down a deep deep hole because of one simple financially focused event.


{ 14 comments, please add your thoughts now! }

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14 Responses to “7 Deadly Sins of Personal Finance: Skipping Emergency Funds”

  1. Regarding an emergency fund, I would add that a HELOC or other form of credit line is NOT an emergency fund, despite popular belief to the contrary. Lenders are now re-assessing such credit lines and indeed freezing them as home values fall.

  2. Frugal Dad says:

    We’ve had a string of bad luck here over the last couple months, from badly sprained ankles to a broken air conditioner to the hospitilization of a loved one. In each case, it was comforting to know the emergency fund was there to help “float” a while if needed. Fortunately, in all but one case we were able to cashflow the crisis out of our normal spending account.

  3. Start-Up says:

    I would also like to add that having a partial emergency fund before beginning to pay down debt is a good idea. I know that if you have significant amounts of debt, it is difficult to begin thinking about saving for an emergency fund, but it’s better to have a small amount in case of minor emergencies like a flat tire. Even if it’s a zero balance transfer card, as most new purchases on those cards do not come with the zero percent interest rate. I wouldn’t recommend a full emergency fund if you have massive amounts of debt, but a small one is helpful.

  4. It has taken me a while to fully appreciate the need for a distinct emergency fund that is separate from a simple savings account, and that it is important to plan for the “worst case scenario.” It really is a good idea to have an emergency fund.

    I think your last piece of advice is the often-overlooked part when people advocate emergency funds — its not really an emergency fund if you are using it for pseudo-emergencies.. its smart to have a solid idea of what constitutes an emergency when you start setting aside money.

  5. Gary Hardin says:

    Encouraging readers to have an emergency fund is a responsible piece of writing. Thanks! We discovered last week that we need a new roof. Yikes! We do have an emergency fund to pay the costs of the new roof. In my old days (days of debt and no emergency fund) I would have been in a panic. In these days (wth an emergency fund) I have piece of mind.

    Gary Hardin

  6. Here’s what we did, we did the usual calculation of 120 – our age to determine how much — percentage-wise — we’d put in the stock market. The rest goes into safe, liquid assets, including our emergency fund.

  7. agriya says:

    yes, I am also did the mistakes in my life, after that I just think about those think then I felt my mistake, now I am clear about my finance any my shopping from now I have to plan well and try to save my money.

  8. Abby says:

    I’m going to raise a bit of hell here and say something a tad controversial: I don’t think emergency funds are a good idea for most people still paying off debt. I know most PF bloggers think it’s integral to save money even while paying off cc debt, I personally think the money can be put to better use.

    I blabbed about this on my own blog, with numbers to back up my argument, but basically the reasoning goes thusly:

    If you’re saving for an emergency fund and have a credit card with, say, 12% interest, the money you’re putting away in the emergency fund isn’t going to be earning an equivalent percentage. So you’re losing money by putting it away for when you *might* need it. Meanwhile the money you already owe is collecting interest.

    I’m not saying this works for everyone, but I think a lot of people haven’t actually sat down and done the math. My husband is on unemployment at present and I’m on disability but we’re still paying down debt and making rent, etc.

  9. I wish! Saving up that sort of money would take me years and years, and as Abby said, would leave me lingering in debt for ages. I don’t deny how nice it’d be to have such a fund, but my god — that’s a lot of money sitting around. A small fund, sure, but 6 months? Maybe if someone starts paying me $150K/year or something, but…not on a single income with a kid in this economy.

    I’d say this is nice…but a pipe dream for all but the upper class.

    • Megan says:

      You build up what you can. Sure 6 mo is high, but what about 3? What about just the amount of all your deductibles? My husband and I are grad students and we have a full 6mo saved plus more for other situations. Just take it in baby steps.

  10. Bruce weaver says:

    I notice on these sites when talking about insurance, no one talks about the advantages of driving an older car. I buy cars when I can know most or all the history of said vehicle. I have an honest, certified indepent mechanic. In my state we have serious winters, so a garage is a must. My ’91 riviera w/145k cost me $28 ayear to register, and $125 every 6 months to insure for 50/1oo liability, with un-insured medical, and roadside assistance. My ’89 chevy truck w/123k is $35 to register and & $110 to insure. I can’t afford to SELL these vehicles. If I wreck at my fault, I am prepared to walk away from my investment. I’dont worry about salt or parking lot dings. I still keep them clean and in excellent repair…and best of all no stress! I keep a 10+ yr old car at least another 5 years.

  11. Anonymous says:

    I just nearly fell off my chair, looking at the post from The Digerati Life. “The usual calculation of 120 – our age to determine how much — percentage-wise — we’d put in the stock market. The rest goes into safe, liquid assets, including our emergency fund.” If you’re aged, say, 40, who puts 80% of their assets in the stock market? Believe me, whoever gave you that “120 minus your age” guff is wildly optimistic about the relevance of volatile (and, in a bear market, frequently-illiquid) stocks to personal asset management, and I don’t care how “usual” that calculation may be. I’d suggest getting a credible financial adviser – quick as you can.

  12. Charles says:

    This is a great article. God bless you.
    This is going to help me inprove my finacial skills.

  13. pj says:

    In the worst of times, the emergency fund is the difference between overdraft fees and staying in the black thanks to silly expenses like wanting gas and groceries in the same week.

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